Bonds in 2015

By Bob Landaas

Absent any measurable inflation, I am confident that when the Fed does eventually raise interest rates, it’s going to be good news, not bad news.

It’s going to be good news from the standpoint that it will show that the economy can weather higher rates; it will show that the economy doesn’t need the artificial propping up of an almost-zero overnight rate and that the economy will do just fine with slightly higher short-term rates.

Interest rates and bond prices move in opposite directions.The longer the duration of the bond, the greater the impact the rate change has. Here’s the math:

Multiply the duration by the change in rate.

So if you have a bond fund of 30 years in average duration and interest rates go up half of a percentage point, the value of the fund drops by 15% (30 times 0.5). If the average duration is shorter – say five years, the value drops less – in this case, 2.5% (5 times 0.5).

Investors need to distinguish between the Fed resetting monetary policy just to get to neutral for the overnight rate, compared to dramatically raising rates to beat down inflation. Those are two very different outcomes.

It has been a number of years since the Fed started raising interest rates. The last cycle of tightening began in the summer of 2004. The Fed spent the better part of two years raising rates.

The transparency now at the Fed is such that it’s going to be baked into the equation by the time they actually do what it is they’re going to do. That’s a contrast to the old days of Alan Greenspan, who kept his cards pretty close to the vest and would have a tendency to blindside the Street with his pronouncements.

The Fed has created nine of the last 11 recessions by raising rates, principally because it was freaked out about inflation. But absent any measurable inflation now, we think the Fed is not going to get aggressive.

It’s going to be like the ending of the third round of Quantitative Easing. Everybody was mesmerized by that for more than a year. By the end, when the Fed stopped its bond-buying in October, it was a non-event. It was as if no one noticed and no one said anything about it afterward. But leading up to that, people were obsessed about whether the Fed was propping up the tent and artificially inflating stock prices.

It could be well into the fall of this new year that the Fed will ultimately raise rates. I don’t think we’ve realized the fallout of low oil prices yet and its potential impact of keeping a lid on inflation.

Low inflation

This past year, we finally saw capitulation from those folks who thought that inflation and interest rates were going to skyrocket because of stimulus measures aimed at boosting the economy out of the Great Recession. Some even thought that we would debase the currency and monetize the debt. None of that came to pass. So I think we can finally say that those folks who thought interest rates and inflation were going to go way up just need to give it a rest.

Along with the plunge in oil prices last year, we saw the agricultural commodities, the industrial metals, the precious metals all declined, really helping keep inflation very low.

One of the big news items from last year was just how much lower interest rates went, and we think they’ll probably surprise folks by staying low for a considerable period. A year ago, nobody was predicting that interest rates would fall. We started 2014 with the 10-year Treasury yield above 3%. It recently closed below 2%.

In terms of interest rates, we’re not really worried about the intermediate or the long end of the U.S. yield curve. It’s textbook that a strong dollar flattens out that curve. The short end is rather steep right now. So that’s the end that we’re kind of worried about – anything less than 2 years in duration. My guess is the intermediate- and long-term end of the market may not move anywhere. In fact, if you had been smart enough to buy the 30-year Treasury, you’d be up 22% for 2014.

Many bond markets

Bond prices decline as interest rates rise. And it’s important to remember that there is not just one bond market. There are dozens of different markets for fixed-income securities around the world.

For instance, we think you’re going to see some pressure this year on international bonds with the stronger dollar. Many companies overseas borrow dollars. And when the dollar strengthens against their currency, it takes more of that local currency to pay back that dollar-denominated loan.

We’ve already seen problems in Russia. My guess is that’s going to spread around the world and particularly hit the oil-producing nations. So we think the stronger dollar is going to be a consistent theme in the financial markets this year.

With domestic corporate bonds, we saw a little bit of a sell-off in December with the high-yield end of the market. Over one-third of all high-yield bonds that were issued since 2008 were issued to the fracking industry. We’re at the point of break-even for the fracking industry – somewhere around $55 per barrel of oil. So we think there will be some continued strain there.

As for the municipal market, most of the national municipal bond funds were up 8% to almost 10% in 2014, having lost 4% in 2013. So, we got past the defaults in Puerto Rico and Detroit. Municipalities – state and local governments – have been very reluctant to spend more money. What is going to help this economy keep growing is when state and local and even the federal government increase spending, as anticipated this year, as opposed to reducing spending.

Another point in the muni market is that very few new municipal bonds were brought to the Street in 2014. The great majority were re-issues. So it’s the law of supply and demand. If the supply of municipal bonds shrinks and demand is fairly constant for people who pay high income tax rates, then you’ll see the prices go up.

When we look at the municipal market now, compared to the long-term average, where municipal rates are 80% or less of the U.S. Treasury rate, then it’s time to buy. In a number of maturities now, munis are over 100% of the yield of U.S. Treasurys, and yet you’re not paying federal tax on that money. So we like municipals. I think for a lot of folks it’s important to own not just corporate bonds but to own municipals too. They trade a little bit differently than corporates. They’re not as liquid as corporates.

Many municipals are meant to be held until maturity, so they tend to get buffeted a bit from time to time. But for folks in it just for the income, or they just need a nice, safe place, I like municipal bonds. They’re a wonderful complement not only to corporates but to the international markets.

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